To introduce the idea of money in Islamic political economy we ask the following questions at the outset: Is money a contravention or a commodity in economic activity? If money is a contravention to promote economic activity, then what is the real output against money must be measured and evaluated? If money is a commodity, then what is the real price of money? In either of these cases, what are the functions of money? Answers to these questions will suffice to explain the meaning of money in Islamic political economy.

We must introduce and explain the meaning of money in Islamic political economy in light of the same knowledge-centered interactive methodology that we have throughout developed for IPE. Such a treatment of the concept of money is of course not new in the literature.

Aristotle thought of money as a contravention with no real value, but he aborred wealth albeit the necessary evil that men possess in aquiring wealth. Thus, although Aristotle saw the unethical element of the rate of interest in the generation of wealth, he maintained its necessity for the human economy. Money in the context of all these facts, turns out to be a contravention driven by the rate of interest for the purpose of accumulation of wealth.

Hume and Fisher saw in money the concept of bullion that is transacted through trade. If a commodity had value, that was because it was made expensively and then traded for cheaper things through international trade. This mercantilist concept of money as bullions was a fallacy that Hume had pointed out. For if expensive goods were produced at home through the supply of an increased quantity of money and then traded for cheaper goods from abroad, that meant an export of money capital while raising prices at home. The mercantilist bullions theory of money was the result of delinking money from the productive roots of economic activity.

Marx saw in the use of money as a contravention that remained independent of economic activity, a fallacy for price stability. He argued that if a given quantity of money (M) was made to transact a certain amount of goods (T), say in trade, then the unit price is given by, p=M/T. Now the lesser is the number of goods, the less is the circulation of that quantity of money. Hence p would increase. On the other hand, the higher is the quantity of money that is created indepednently of the level of economic activity (T), then this too will create price increase. Finally, if M was low in quantity and was independent of T, then T would be generated by other means, such as, barter and book-entry means of transactions. This was practiced by the Soviet Gosplan for a long time. But if M is related with T, so that functionally, T=T(M), then lower M would mean lower T(M) and vice versa. p would now remain stable but at the social cost of prosperity. Finally, if both M and T(M) were high, then too p could remain stable. But now the mere contravention of money must be abandoned.

The treatment of money as a commodity is not to be seen in the classical school with its rebirth in new classicism. Thus from Adam Smith, Hume to Marx and later on Walras and Hayek, today Friedman, all see money as a contravention and not as a commodity. The meaning of contravention is that of money affecting the level of economic activity and to be thus evaluated in terms of the return to capital.

With the neoclassicists and Keynes, the quantity theory of money came to be challenged by the commodity concept of money. This meant a return to yet another view on the commodity concept of money from that held by the bullion theory of money in the mercantilist school. To the neclassicists, money represented a dated exchange intertemporally, just like any commodity. Hence, there must be a price for evaluating money as such dated commodities. To Keynes, money as commodity is interpreted in the way it is held. Hence, a transaction demand for money held meant the use of money for immediate needs into alternative sources. This kind of activity did not qualify money to be held as a commodity per se. Rather, the real outputs transacted by money provided the money substitutes of commodities. In the precautionary and speculative demand for money functions, the commodity nature of money is reflected by the perception of the holder on what money does. That money now serves a certain psychological behaviour assumed by Keynes to characterize uncertainty and haste. The latter was also neoclassical in essence. Money as commodity that is held as traded exchange intertemporally, always had a subjective pricing to it, that was called interest rate.

Thereby, only when money is held as a commodity directly and not in terms of the real goods it serves, and only if money is a contravention independent of real economic activity, then this aggregate comes to be held in subjective perspectives. Interest rate now becomes a price for money held as commodity with a subjective pricing. In recent quantity theory of money, the combination of money as both a transcation (securities) and a means for real goods transactions, makes the theory also relapse to accept interest rate as a price for such dated exchange of money as commodities.

If it was thus possible to logically eliminate the connection between the nature of money and its subjective pricing when held as a commodity or a contravention over time, then the rate of interest would become a wasteful cost. All valuations of goods would then be reduced to real economic activity. Intertemporal treatment of goods in exchange would proceed in the light of real goods exchange. What we would hold is not money but goods. Money would then lose its functions of exchange. It would reflect simply a store of value imputed by the exchange value of the real goods. In this light then, capital markets, financial institutions, international transactions and monetary currencies, would all be treated in terms of real sector activities. Money would cease to be a commodit, but will continue to be a contravention that is functionally determined by the level of real economic activity, current or expected.

Islamic political economy is the study of knowledge-induced interactions among economic participants, institutions and ideas once the interactive-integrative-evolutionary nature of the unification process emanating from the epistemology of Divine Unity is held. In this light therefore, money must be seen as the result of a series of interactions in real sector activities that primordially create a thing of economic value. Thereafter this value reflects the configuration of money in the system. To look at this technical issue we return to Chapter 3.

Let k denote knowledge flow that in turn creates time t as a reflection of event upon time. Thereby, k determines t and t thereby determines socioeconomic values denoted by the vector X(t(k)). Now since all possible combinations of k in the domain of interaction-integration-evolution equivalently generates all similar combinations of X(k(t)) values and in similar domains, therefore, V1=U(INT(k(t))) ->s U(INT(X(k(t))). Here U denotes mathematical union and INT denotes mathematical intersection. Thus, s(U(INT(k(t))) as a mapping of a domain must belong to the `onto' domain, U(INT(X(k(t))))=V2, say. The assumption of monotonicity between s(.) and V2, and hence between V1 and V2, is automatically made. The topological space in the sense of such domains is the vectorial tuplet, (V1,V2). The monotonic functional defined on this topological space is, S(V1(k(t)),V2(k(t)). The important difference between S and the concept of social welfare function used in neoclassical economics is the existence of universal complementarity among V1 and V2 through the effect of k over time and systems. In the neoclassical economic theory there must ultimately be gross substitution between V1 and V2, although partial complementarities may exist. One representation of S(V1,V2) is, S=Product.[M(g,k)], where now we take V2=M(g,k) as money defined by its evaluation parameter g in terms of knowledge value k over time t.

Now we have a way of examining the recursive nature of money in the Islamic political economy. M(k(t)) is the result of knowledge values k that are formed by institutional-economy-markets and agent interactions. Since interactions are real events in space-time, therefore, money must be a functional product of such real events. Speculation as any means of valuation cannot be acceptable in this knowledge-based interactive order.

The recursion nature of the interactive-integrative- evolutionary system of Islamic political economy leads to the following simulation problem involving money:

Simulate(k) Prod[M(g,k)] subject to, M+(k+) = f1(M(k)), k+ = f2(k). 

values with + indicate forward recursive values. Although simulation over k-values does not hold monotonicity of such values, yet the relationship between M and k and various combinations of these, is strictly monotonic. This means that the growth parameter, g must be a monotonic function of k-values. Now since k are generated by interactions, an example of which is participation in real economic activitiy, therefore, g must be a measure of profitability, growth rate of output and prices of commodities in actual transactions in the real economy. Money in the Islamic political economy is thereby a contravention and not a commodity. But it is a contravention strictly as a determinant of the value created by real sector activity. The growth of money-value as such a contravention is imparted by the real sector growth rate, profitability rate, rate of changes in prices, g(k).

The question we now want to examine is whether the same kinds of growth effect can be given to money by the rate of interest? Let us proffer an answer from the Keynesian side. In the Keynesian economic system, an increase in interest rate as a policy variable set by the central bank is accompanied by a decrease in money demand and money supply. With this monetary contraction, the immediate effect is a decline in national income, investment and employment. Increased interest rate gives incentive to savers at the cost of resource mobilization into real investment immediately. There is a waiting time before savings can once again be so mobilized. During this waiting time, productivity is lost and along with it holding of money as savings translates into an inequitable resource allocation in favour of those who can earn and save in these high unemployment regimes. Interest rate thus becomes a price for holding on to savings as liquidity and thus withdrawing funds from productive economic activity.

Examining the money relation from the side of the quantity theory of money, we note the fundamental equation, MV=PT. Thus, M=k.P, where, k=T/V is assumed to remain fairly constant. This implies that an identity exists making the relationship between P and M two-directional. The consequence is a lack of a well-defined causal relationship between these variables and the resulting absence of a deductive theory of money and prices except as an a posteriori empirical fact.

Barro's market clearance model links up the market for commodities to the money market. But, since real incomes remain unchanged in a given menu of production, so Barro's commodity market model determines the equilibrium level of interest rate and output. When these are substituted in the equation for the demand for money, money market clearance takes place at equilibrium levels of price and quantity of money. The linkage created between the two markets is therefore through the inverse movements between price level and interest rate. Interest rate thus once again becomes a behavioural valuation factor rather than a real creation of market exchange. Barro's market clearance model does not provide a rationale as to how the interest rate leads to and emerges from the clearance between the two markets, except that it feeds in from the commodity market determination to the money equation. In the commodity market interest rate is the creation of an intertemporal valuation of perceived though not real scarcity.

From all of the above perceptions on the rate of interest in conjunction with money and prices, we obtain the following observed relationship:

M E Q P Q/P I S r U(i,X) i increasing - - - + - - + - i,X subst t time increasing i: interest rate (nominal or real); I: investment; M: quantity of money; Sv: saving; E: employment; r: profitability rate; Q: output; U(i,X): utility function P: prices; in terms of i and X as Q/P: real output; substitutes; X=(M,E,Q,P,Q/P,I,S,r). 

Next we will examine the above question of valuation of money in Islamic political economy. The relationship between the real rate of profitability, g(k) in terms of the knowledge variable k, and in relation to quantity of money to be determined by and to support real economic activity, showed that such a rate is caused by a wide range of participatory functions. Thus, money ceases to have an independent existence of itself either as an aggregate or as a time-valuation commodity. Only real economic activities count. Money is a contravention to support these activities and to be created in turn by such activities. The last point is that of recursive simulation as we have formulated.

Now then, k determines price level, p(k), which determines g(k), ..., which determines X(k), which determines M(k). In turn through the recursive simulation problem, M(k) determines X(k), and thereby, by the reorigination of knowledge variables, new k-values emerge. This circular causation continues.

The recursive problem and the relationships between M and X are now as follows. In the Islamic political economy, the interrelationships between money and real economic activity are given by,

M = F(X(k),k), 

subject to a series of derived relationships between any one of the X-variables and the remaining ones in X; and the recursive equations, M+ = f(M(k)); k+ = g(k), the symbol + denotes forward recursive values. It is clearly seen that through these recursive equations, all variables in the derived equations of the X- variables are recursively determined. The simulation of M-X relationship here points to the cause-effect feedbacks between money and the real economy.

The M-X relationship is now through the cumulative effect of g(k) instead of being through i. The effects as follows:

M E Q P Q/P I S r S(g(??),X(??)) g(??) + + + + + + + + complementary between g,X, as explained earlier. k monotonically related with X(k) but not so with time t, as knowledge changes can go all ways over time. The created nature of t by means of k is to establish the observational capability of the X-values over time. Hence, X=X(t(k)).

The positive relationship between g(k) and S is afforded by the reinterpretation of saving as an increased amount of resources channelled into productive investments without undue waiting time cost. The price level P is non-inflationary, because since the growth effect of M is determined by g, the latter must also determine the growth of prices in the midst of the commodity-money feedback linkages. Hence, M/P approximates to Q/P. That is, Q/M is stable, meaning that the productivity relationship is sustained in the midst of the quantity of money. Now if in any of these variables the effect of k is not uniform, then the stability relationship would not hold as g of money would be different from the r of Q and profitability. As k increases over series of economic epochs, there is a tendency to attain g(k) instantaneously in any phase, but only to acquire newer such values over subsequent regimes of change.

Where then lies the difference of such a definition of money centered around endogeneity of real sector activities from that given by Keynesian or quantity theories? We will explain these differences by examining the comparative meanings of equilibrium in Islamic political economy and other systems.

First we will look at the usual monetary equilibrium with interest rate (i) and money (M) relations in demand and supply. The intersection of money demand (Md) and supply supply (Ms) determines the equilibrium interest rate and quantity of money. But at the same time, there comes about a corresponding equilibrium levels of X(t) and M(t) relation. We have approcimated X(t) by the price variable only, P(t). These simultaneous equilibria are shown by the points like E1 corresponding with e1. But as decreased interest rate policy shifts Md to Md'; Ms to Ms'; Xd to Xd'; Xs to Xs'. Now E1 shifts to E2; e1 shifts to e2. This is the picture expected in the Islamic concept of endogenous monetary relations with real economic activity. It also signifies an economy in the process of transition to an Islamic political economy with declining i.

Next we show that as i increases (i1 to i2) , the production menu is adversely affected. Both due to increased cost of investment and the consequent increase in prices due to scarcity, will cause inflationary pressures arising from the cost- push side. The effect will be a decline in the quantity of money (M to M') available for spending. Whereas, we note in figure 1, that increasing prices driven by productivity gains will establish a direct relationship between M(t) and P(t) with declining i.

Thus there is an inconsistency between the relationship of M(t) to P(t) caused by an increase in P(t) as a monetary phenomenon and by productivity gains. The presence of active interest rate policy being endemic to both the Keynesian and quantity theory of money, as we have noted above, now gives opposing signals for the strictly endogenous monetary relations in the Islamic political economy. Islamic theory of money and the monetary aggregates are therefore endogenous in nature and provide a spending related concept linked with real economic activity. Likewise too, as we have pointed out earlier, such a usage turns money into a contravention that can have no independent exchange value but simply a store value with stability. The stability property is introduced from the side of Q/M relationship. Through the uniform effect of prices on money and output, price stability is attained and is linked to productivity.

The endogenous theory of money in Islamic political economy brings us to examine the following problem. Note that each of the variables is a function of ??(t), which we do not show. The rate of change of quantity of money, m is given by,

m=(1/M)(dM/dt)=del(1/F)(delF/delx)(dx/dt)=(delq(x)/delx).dx/dt, 

where, x is an element of X; q(x)=(1/F)(delF/delx) denotes the contribution of the x-element to the growth in the quantity of money in real economic activity. We furthermore note that each of the q(x) is recursively interrelated among the x-elements through feedbacks. Thus, the above measure for m is recursively solved by means of interactions among the derived relations of any x in terms of the other x-elements of X(t). The institutional meaning of such a relation is that creation of any socioeconomic value and hence of money, is now automatically determined in the economy. Rather in all actions an anthropic presence is required.

One of the important elements of X(t) is investment demand, I. We know for the business cycle that in hyper-inflationary peaks, I and P tend to be inversely related making the economy swing back to full-employment equilibrium. How are we to explain the I-P relationship in an Islamic economy?

We note that increase in M and I can be at a cost if there is a slack in the expected one-to-one feedback between k-values and M,I values. There is nothing to ascertain that such a one-to-one interrelationship will exist. Because the politico-economic system goes through interactions into temporary integration (convergence of k-values) followed by continuity of the process (i.e. evolution of k-values), therefore there are phases of limit points for k- values. In the limit of k tending to k*, over given set of interactions and convergence of organizational rules, temporary equilibrium values (M*,I*,P*) come about. However, these are replaced by subsequent new values as new knowledge-induced dynamics continue. That is, (M*,I*,P*,k*) is an instantaneous point of local equilibrium in any particular phase of interactions-integration. But in the global sense there are no unique equilibrium.

Such multiple equilibrium paths between (M,P,k) are shown by (e1e2), (e2e3) etc. These are reproduced in figure 3. The nodes of emergence to new k-values at temporary (instantaneous) equilibrium points like e2, e3, etc. are permanently perturbed points. Now by an equivalence between event (k) and time (t) the multiple equilibria changes are also charted over time while we are charting them over assignments of k-values.

Hence there are permanently increasing relationship between M,I,P as lone as k is increasing globally. Within this global change, only instantaneous equilibrium values are attained. In the global sense multiple (M,I,P,k) values exist. Such a result is consistent with the simulation problem given earlier.

How can we explain the relationship between the reserve ratio and the inter-bank loans with increasing demand for liquidity for investment? We note here that since inter-bank loans will increase in the face of increased demand for investment, therefore the reserve ratio (say r') will decline. Now, change in money supply, delM will be related to the increase in inter-bank deposits (signifying demand for liquidity), delD by the following multiplier relation: delM=delD/r'. This is an increasing function of r' declining with increased demand for liquidity for investment.

Let B1 and B2 be two banks engaged in inter-bank loans. Under transactions on a profit-sharing contract in an investment venture, let g1 denote the return to B1, which then forms asset for B1. Let g2 denote the return to B2, which then forms a liability to B1. Likewise, g2 forms a return to B1 and g1 forms a liability to B2. The balance sheet of the two banks will appear as follows:

Inter-bank Balance Sheets B1 B2 B3 initial deposit = $1 initial deposit = 0 new deposit=g3 new deposit=1.g2 retention=g3g3' retention=1.g1 retention=1.g2.g2' loan=(1-g3')g3=g4 loaned=investment loan=(1-g2')g2=g3 in joint venture=1.g2=1-g1) 

Thus new money in the economy equals the amount of investment capital (or loan capital). In a multiple bank loan case under joint venture, the total new money or investment capital, delM in the economy equals,

delM = g2+g3+g4+..........= g2+g2(1-g3')+g2(1-g2')(1-g3')+........ = g2[1+(1-g2')+(1-g2')(1-g3')+......]

Only when a fixed reserve ratio is applied can this expression revert back to the usual monetary multiplier expression. But in the Islamic political economy, where interactions and recontracting constantly revise the profit-sharing rates among joint venturists, and the increased demand for investment must reduce the reserve ratio to zero, giving money a 100% liquidity value, a fixed g-value would be impossible. As shown in the above expression, new money in the economy equals an initial deposit, g2 increased by, [(1-g2')+(1-g2')(1-g3')+....], which denotes the cumulative value of all loan rates (investments) in multiple inter-banks transactions. These g-rates are equivalent to the profit-sharing ratios, for the profit-sharing ratios are set at the time of contract of any joint venture.

In the final analysis we must examine what mechanisms exist in the Islamic political economy through economy-institution interface to ensure that such rates will be high. The performance of high g- rates depends upon both organizational efficiency, honesty and rightly guided investments. To attain all these means the avoidance of the moral hazard problem in a profit-sharing type of banking system. But the avoidance of the moral hazard problem assumes an explanation that is different from that given in the neoclassical economic literature on moral hazards and investment portfolios. We now undertake a brief look at this issue respecting to the Islamic profit-sharing ventures.

In the neoclassical sense, let L denote loans; R denote the vector of interest rate (i) and price level (p). The utility function of the loanee is given by, U=U(L,R). Consider now the effect of i and p increasing together as in the hyper-inflationary regime in a business cycle. Then dL/dR 0, but dU/dR 0, dU/dR 

In a neoclassical approach to the moral hazard problem, the loanee benefits from increased interest rates by borrowing say in a profit-sharing market at zero rate of interest and depositing the loan in an interest bearing financial instrument. Hence the marginal utilities of the cheater with respect to both R and L, with prices remaining always stable in the neoclassical sense, are positive. Now for optimal utility of the loanee,

dU=(delU/delL)dL + (delU/delR)dR = 0' giving, dL/dR = - (delU/delR) / (delU/delL) 

Thus the neoclassical approach to the moral hazard problem keeps the loanee insulated from the monetary realities and simply entrenched in his own self-interest. Interactions between the loan market, the monetary impacts of higher interest rates and the self- interest of the loanee are ignored in the neoclassical treatment of the moral hazard problem.

Now to consider the moral hazard problem, a person would take out a loan to his benefit to earn an interest on it, while prices remain stable. Hence, increasing interest rate regimes through loans and savings bring about increased utility to the loanee. In the midst of such interactions, delU/dR > 0, delU/delL > 0, dL/dR > 0, signifying that the neoclassical solution is now untenable and the meaning of R and L are to be changed from that given in the monetarist environment or in the neoclassical economic environment. 

In Islamic political economy, R=(g,p) and L=L(g,p) denotes investment resources (the meaning of investment can be taken in the broad sense of human capital investment, social investment as well as real investment). Now only can there exist a positive relationship between L, g and p. Money in this system grows under the impact of p and g, due to the endogenous effect between money and prices (growth and profitability). Thus dL/dR > 0. The moral hazard problem of the neoclassical type is thus non-existent in the Islamic financial case. The moral hazard problem of loans market in Islamic political economy is a function of the degree of institutional/organizational efficiency, honesty and tenacity interacted with the efficiency gains of the real economy. This simultaneity of the interactive process can only be attained by means of knowledge simulation among the players. If there is reduced L, that is because there is low economic activity and hence low level of knowledge generation through interactions in the Islamic economy at any time. This condition too leads to dL/dR > 0. 

We now conclude this brief note on the theory of endogenous money in the perspective of Islamic political economy. We have seen that there is a direct relationship between money, prices, growth, profitability and all socioeconomic variables characterizing real economic activity. Speculation is replaced by the actual or realizable expected prospects of such values. Yet the endogenously circular relationship between money and prices is from the side of prices impacting upon money. Thus money has been shown to be a contravention rather than a commodity by itself. In this sense, the Islamic theory of endogenous money is distinct from that given by Keynes and the quantity theory. The contravention of money is thus treated as a creation and carrier of information (knowledge =interactions) in the real economy. In the language of the circular flow among interactions, integration and evolution of real quantities, this relationship caused by the contravention of money can be represented as follows: k -> (X -> M) -> k+ -> (X+ -> M+) -> etc. + values denote recursive values and the bracketted relations show that M always remains a contravention in economic activity in Islamic political economy